Swiss clouds hanging over Central Europe.

Dear readers,

This week we would like to address another imbalance that is shaking up the financial system, more specifically recent strength in the Swiss Franc (CHF).

Several board members of the Swiss National Bank (SNB) have recently expressed their concern on the strength of their Swiss Franc. Even against the EURO the Swiss currency has gained more then 7 % over the last couple of months. The move in September can easily be explained by the Lehman event, where the market went into total risk aversion. The Swiss Franc has been over time one of the ultimate safe heavens together with gold in times of crises.


But the picture against Central European (CE) is even more dramatic. The Polish Zloty (PLN)lost 50%. The Hungarian Forint lost over 36 %, and the Czech Crown fell by more then 32 %. This move is even more dramatic compared to the EURO, but this can easily be explained by emerging markets which were hit quite hard in the second half of the year due to the ongoing crisis and capital repatriation from these countries.

The rally of the CHF against those CE currencies is even more worrisome due to the fact that over the last 5 years local banks have been lending mortgages in other currencies, such as CHF, EUR and JPY. CHF denominated mortgages were the most favourable ones creating a huge potential foreign exchange risk for home owners in Poland – Hungary - Czech Republic to name a few.

On several occasions we have been referring in our weekly commentaries to the imbalances that have been built up in the global financial system. The very lose lending standards that were applied in Central Europe by local banks are one of those. The loans were sold massively to retail / real estate buyers with the teaser that all these countries would benefit from further European integration and as a result their local currency could only strengthen on the back of this. Of course the very low interest rate on the mortgage was the sale argument to close a foreign currency denominated mortgage.

Unfortunately these clients were not realizing they were putting on a similar carry trade like the rest of the investment world was building up year after year. As the chart indicates after the mild recession at the beginning of this decade all these countries started at a phenomenal growth pace. The currencies were strengthening and this gave first home buyers a false feeling of personal wealth creation.

Now that the tide has turned quite rapidly all these mortgage lenders see themselves squeezed between a fall in property prices and a dramatic rise in their outstanding debt they need to pay back. A numerical example will make this whole process more clear:

Suppose client Mikolaj Sikorsky steps to his bank for a mortgage on the house he wants to buy for the amount of PLN 325.000 (ca. EUR 75.000). The bank offers him the choice to either borrow PLN 325.000 at a rate of 9.50 % with a maturity of 20 years, or to borrow CHF 147.725 at a rate of ONLY 3.00 % for 5 years. In the loan agreement is written in small letters the outstanding amount will have to be paid back after 5 years and if during the tenor of the loan agreement the exchange rate of CHFPLN is breached above a level (e.g. 3.00) the loan needs to be early redeemed. As in every mortgage is the case the underlying house will be used as collateral.

Our client Mr. Sikorsky (not) surprisingly chooses for the CHF denominated mortgage and receives from Polanska Banka the amount of CHF 147.725. However to close the deal with the current owner of the house he needs to convert this CHF into PLN which is now trading at 2.20, since the seller does not want to have CHF. The transaction goes very smoothly, since Polanska Banka is quite happy to assist Mr. Sikorsky in all this. Even paying the monthly CHF interest rate goes without any problems, since he notices that in PLN the amount debited from his account is less and less every month.

However during his summer holiday at the Black Sea in August, he receives a call from the bank that his account is in overdraft, and that he needs to credit his account since there are not enough funds available to pay the monthly amount on his mortgage. Although the amount is negligible it was a bit awkward since he got used to pay the monthly amount to the bank at an ever lower PLN amount. Basically what happened was that the CHF in the mid of the credit crisis of last summer was starting to rise, and effecting our clients monthly payments.

By October things get worse, and Mr. Sikorsky notices he is now paying 25 % more every month since last May and he will have to change his expenditure pattern. Later that month he receives a call again from the bank, saying there might be a problem with the loan. The CHFPLN exchange rate has been rising aggressively (2.60) and although there is no reason to panic yet they would like to have a discussion with him whether he would have extra funds available in case for additional collateral, if not (and still highly unlikely) his house might have to be confiscated in case the CHFPLN would touch 3.00.

Even if all things stay the same for now, Mr. Sikorsky will have to take into account that in 3 years time the repayment of his mortgage at maturity is going to be more expensive. The problem is our client borrowed CHF 147.725 which he converted immediately into PLN in order to close his housing deal. At the current rate he will have to buy PLN 384.085 in order to give the CHF amount back to the bank. This is PLN 59.090 (or 18%) more then he initially paid for his house. In order to prevent to lose more money he starts to convert part of his savings already in CHF to prevent to make things worse.

The above described story is not fiction, and neither it’s something to laugh with. This happened and is happening to a lot of people in Central Europe. Basically what happened above is that our client was sold a forward currency contract on a margin call basis.

Just to give our dear readers an idea of the extend of the problem, only in Poland up to apx. PLN 88 bio – or EUR 20 bio – was lent to Polish mortgage borrowers in foreign currency denominated amounts. The total amount for the whole region – Central and Eastern Europe – is estimated at $ 1.6 TRILLION tied to the consumer and not the corporate market. (source: Morgan Stanley)

With access to capital now drying up worldwide, banks have stopped lending in foreign currencies and are calling in outstanding debts as they look to raise capital anywhere they can. This has left a lot of consumers unable to pay back their mortgages and increasing the concern of potential default of Central and Eastern European countries’ foreign currency related debt.

It is also due to this kind of exposure that the credit agencies red flagged Allied Irish bank, which was a heavy lender into Central and Eastern Europe. A total exposure of $ 1.5 trillion is at the expense of Euro-zone, Swiss and Swedish banks who were lending massively to these countries on this basis.

This explains the nervousness of the SNB as their currency is getting squeezed in the turmoil and they would use the intervention weapon to turn the tide. If this is going to help is another question, as history proves little success in these operations. Once a currency starts to slide there is little a central bank can do. Ask the BoE…

I wish you a very nice relaxing weekend.

Gino Landuyt